Introduction to Economics

Limits, Alternatives & Choices

Aims & Objectives After studying this lesson, you would be able to understand What is economics? Concepts like scarcity & choice Microeconomics Vs Macroeconomics Individual’s & Society’s Economizing Problem Society’s Production possibility frontier Economics & managerial decision making 3

What is economics? Economic wants exceed productive capacity → scarcity → calls for optimal choice making Economics is a social science concerned with making optimal choices under conditions of scarcity. 4

Scarcity & Choice Scarcity of goods refer to a situation in which goods are limited relative to desires ⇒ Choices must be made ⇒ there is a cost of making a choice called Opportunity cost 5

Microeconomics & macroeconomics Economics is divided into two major subfields – Microeconomics – concerned with the behaviour of individual entities such as households, firms & markets. Adam Smith (The Wealth of Nations, 1776) is considered the founder Macroeconomics – concerned with the overall performance of the economy i.e. aggregate behaviour of the economy. John Maynard Keynes (General Theory of Employment, Interest and Money, 1936) is considered the founder of modern macroeconomics. Note: the present course discusses microeconomics with focus on Firms, Markets & their behaviour 6

Individuals Economizing Problem An individual has limited income but unlimited wants → he faces a problem of constrained optimization i.e given his budget he has to make the best choice posssible 7

Society’s Economizing Problem A society has scarce resources – land, labour, capital & entrepreneurial ability It has to decide how to allocate these limited resources among thousands of different possible commodities & services To summarize: given resources are scarce relative to wants, an economy must choose among different potential bundle of goods, select from different techniques of production and decide in the end who will consume the goods Given this problem facing the economy two concepts are very important:  Inputs – commodities or services used to produce goods & services. Also called factors of production  Outputs – various useful goods or services that result from the production process & are either consumed or used for further production 8

The Production Possibility frontier (PPF) PPF shows the maximum quantity of goods that can be efficiently produced by an economy, given its technological knowledge and quantity of available inputs. Economic growth shifts the PPF outward 9

PPF & Opportunity cost In a world of scarcity, choosing one thing means giving up something else. The opportunity cost of a decision is the value of the good or service foregone. This is a very important concept in economics As we move up the PPF, good X is given up to have additional quantities of Y. The opportunity cost of producing additional Y is the amount of X foregone. 10

How is economics useful in managerial decision making? Evaluating Choice Alternatives  Identify ways to efficiently achieve goals.  Specify pricing and production strategies.  Provide production and marketing rules to help maximize net profits. Making the Best Decision Economics, in particular managerial economics, can be used to efficiently meet management objectives. Economics, in particular managerial economics, can be used to understand logic of company, consumer, and government decisions. 11

The market system & Circular Flow

Aims & Objectives After studying this lesson, you would be able to understand Economic Systems Command Economy and Market Economy Fundamental questions facing an economy Circular Flow of Income 13

Economic Systems Economic systems are a set of institutional arrangements and a coordinating mechanism to solve economic problems. Economic systems differ in two important ways: ▫Who owns the factors of production and ▫the method used to coordinate economic activity The two fundamentally different economic systems are: ▫Command economy ▫Market economy 14

Command Economy Known as socialism or communism Government ownership of resources Decisions made i.e. economic activity is coordinated by a central planning board. ▫ Libya, Myanmar, and Iran. 15

Demise of Command System Soviet Union, Eastern Europe, and China System was a failure The coordination problem The incentive problem 16

Market Economy Known as capitalism Private ownership of resources Decisions based on markets ▫ Australia, Switzerland, and the U.K. 17

Characteristic of the Market System Private property Freedom of enterprise and choice Self-Interest Competition Markets and prices Technology & capital goods 18

Private property Private individuals and firms own most of the private property (land and capital): Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property. Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth. Property rights extend to intellectual property through patents, copyrights, and trademarks. 19

Freedom of enterprise and choice Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice. Freedom of choice means: Owners of property and money resources can use resources as they choose, workers can choose the training, occupations, and job of their choice, consumers are free to spend their income in such a way as to best satisfy their wants. 20

Self-Interest Self interest is one of the driving forces in a market system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction. As each tries to maximize profits, income, and satisfaction, the economy will benefit if competition is present. 21

Competition Competition requires two or more independently acting buyers and sellers. This serves to decentralize economic power. Also, it requires freedom to enter or leave the markets. 22

Markets and prices Markets and prices: this characteristic reflects that the decisions made on each side of the market determine a set of product and resource prices that guide owners, entrepreneurs and consumers as they all make choices based on their respective self-interests. 23

Technology & Capital goods  Market systems reward individuals and businesses for development of new technologies thereby encouraging their development and implementation. Specialization allows economies to take better advantage of their resources and their capabilities. 24

Active but limited Government Although the market system promotes efficiency, it has certain shortcomings. There may be over production of goods with social costs, and an underproduction of goods with social benefits. There are tendencies for businesses to increase monopoly power. Hence Government intervention is observed as and when required 25

Five fundamental questions facing an Economy All economies whether a market system, or otherwise, must address the following five fundamental questions: What goods and services will be produced? How will the goods and services be produced? Who will get the goods and services? How will the system accommodate change? How will the system promote progress? 26

Circular flow of income Let us for the time being assume a simple economy which has no government and is closed. The economy has only two sectors: Households & Firms Households Firms Factor services (land, labour, capital & organization) Payments for factor services (rent, wages, interest & profits) Payment for goods & services Goods & services Refer next slide for complete diagram 27

Abroad Government Households Borrowings & imports Firms Pay for imports & borrowings Imports Taxes (T) Transfer payments Payments for goods & services Goods & services Factor inputs (land, labour, cap, org) Factor incomes (rent, wager, interest, profits) Banks Payment for goods & services & subsidies Exports & pay for imports Imports & pay for exports Interest rate (lending rate) Y Y d = Y - T = C+S Demand & time deposit Interest rate (deposit rate) Reserves CRR, SLR, repo rate Securities & Gold Bond Mkt. Payment for imports Loans 28

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